Revisiting the Determinants of the Term Premium

In last Thursday’s post, John Kitchen recounted our joint work on what amount of foreign financing would be required to make consistent projections of government debt, and short and long term interest rates. That article from International Finance is now freely available on the Council on Foreign Relations websitehere.

One issue that people have raised is how our specification for the term premium is consistent with expected inflation.

The expectation hypothesis of the term premium would state that the long term rate is equal to the average expected short rates over the relevant period; in that case, higher long rates might be due to the higher short rates associated with anticipated future inflation. However, one can add a liquidity premium for a given maturity, assuming there is a preferred habitat motivation. Then, the yield curve need not necessarily represent merely a measure of expected future inflation. In other words, we assume away complete arbitraging away across maturities.

Figure 1 depicts the entire yield curve. We didn’t estimate the determinants of all the term spreads, only the 10 year – 3 month spread. Specifically, we estimated:

The result should be highlighted in part because it illustrates the point that domestic private demand for government debt, as proxied by the unemployment gap, also comes into play. Those who worry about elevated interest rates shouldn’t stop worrying – but they should keep thinking about whether unemployment is likely to decline rapidly, when doing their worrying.

(Regressions for the levels of long and short interest rates, as well as using debt instead of deficits, are in the appendix to the paper.)

This post originally appeared at Econbrowser and is posted with permission.